Will I Need to Pay Taxes on an Inheritance From a Living Trust?

A living trust won't eliminate inheritance taxes, but it will prevent a trip to probate court. (Image: Hemera Technologies/Photos.com/Getty Images)

Living trusts are simple legal structures that have advantages for the grantors and beneficiaries of an estate. An estate’s owner draws up a living trust while he’s alive and dictates to a trustee the conditions of allocating his estate after he passes. Living trusts aren’t a panacea for inheritance-related issues such as taxes, but they can streamline the estate-distribution process.

Inheritance Taxes

Depending on where you live, you’ll need to pay taxes on any inheritance you get from a living trust. A living trust doesn’t protect beneficiaries of an estate from inheritance taxes, which they pay when they take possession of assets. There is no federal inheritance tax on beneficiaries, but as of the time of publication, eight states levied inheritance taxes: Indiana, Iowa, Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania and Tennessee. If you don’t live in a state with an inheritance tax, you won’t pay the levy upon receiving an inheritance.

Estate Taxes

The federal government levies an estate tax, which the deceased’s representatives pay upon transferring the estate to beneficiaries. A living trust will not protect a grantor from paying estate taxes, either. What could head off the tax is the size of the estate. At the time of publication, only estates worth $5 million or more -- or $10 million or more for couples -- were subject to federal estate taxes. Above those thresholds, 35 percent of an estate goes to taxes, even if the assets are in a living trust. As of publication, 14 states had estate taxes on top of the federal levy: Connecticut, Delaware, Hawaii, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, Ohio, Oregon, Rhode Island, Vermont and Washington.

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What Living Trusts Can Do

Though you can’t dodge inheritance or estate taxes through a living trust, the asset-protection vehicles do have important benefits. The trusts allow the estate to avoid probate court, which means the estate is distributed more quickly — within weeks, rather than months — and legal expenses stay relatively low. Avoiding probate court also keeps the trust’s asset distributions a matter of private record. Because the details of asset ownership are private, it could be harder for a grantor’s creditors to track down and pursue inheritors to settle debts against the estate.

Avoiding Taxes

There are several legal options for reducing or eliminating taxes on an estate or inheritance. The holder of an estate can slowly shrink his assets below the estate-tax threshold through annual tax-free gifts to inheritors. At the time of publication, federal law allowed grantors to give individuals $13,000 a year tax-free. Credit-shelter or bypass trusts, which take advantage of federal laws allowing a spouse to leave his surviving partner an unlimited estate tax-free, and irrevocable life insurance trusts, through which life insurance benefit payouts become untaxable as part of the trust, can also curtail taxes. These are complicated estate-planning options, so consult an attorney to discuss them in detail.

Caveats

Even with a living trust, a grantor still needs a will to ensure all of his assets are distributed according to his wishes. If an estate owner buys property or investments and dies before he transfers them to his living trust, the newer assets could be subject to probate. A will can include a general provision noting that all real estate holdings go to a specific beneficiary. You may not need to hire a lawyer to draw up a basic living trust. Do-it-yourself legal websites as well as self-help books and software can guide you through the process.